*2620 1. Income was overstated by the amount of certain expense items erroneously charged on the petitioners' books to capital asset accounts.
2. Deduction on account of the discontinuance of the use of certain patents disallowed for lack of evidence.
3. Reduction of invested capital on account of alleged insufficient depreciation charged off in prior years sustained for lack of evidence.
4. Certain accounts of officers maintained for the purchase of stock represented bona fide accounts receivable and should not have been excluded from invested capital.
5. Proceeds from the sale of property were never included in income, but were credited to the property account and invested capital should not have been reduced by the amount of them.
6. Commissioner's action in excluding from invested capital the cost of additions to plant and equipment approved for lack of evidence.
*338 This is a proceeding for the redetermination of a deficiency in income and profits taxes in the amount*2621 of $4,886.04, asserted by the Commissioner for the fiscal year ended July 31, 1919. The petitioners allege that the Commissioner in his determination of the deficiency erred by (1) overstating consolidated net income to the extent of $33,967,31; (2) reducing earned surplus and consolidated invested capital, because of alleged inadequate depreciation charged off in prior years; (3) deducting $7,086.76 from invested capital through the disallowance of an account receivable due Mathis Brothers Co.; (4) deducting $29,316.26 from invested capital because of the alleged purchase of its own stock by Mathis Brothers Co.; (5) deducting $1,000 from invested capital because to that extent the book value of land and buildings of the New York Blower Co. represented appreciation in value; (6) adding $15,768.50 to invested capital because of the alleged understatement of income of the preceding year; (7) adding $1,600 to invested capital because of the alleged understatement of income of the preceding year; (8) reducing invested capital on account of income and profits taxes for prior years erroneously computed; (9) deducting $9,000 from invested capital because the proceeds from the sale of certain*2622 real *339 estate sold at cost were alleged to have been included in income in a prior year; and (10) failing to add to invested capital the cost of additions to plant and equipment, totaling $128,065, charged to expense in prior years and disallowed as deductions in income-tax returns.
FINDINGS OF FACT.
Mathis Brothers Co., an Indiana corporation with its principal office at Chicago, Ill., was organized in 1903, and is engaged in business as a heating and ventilating contractor.
The New York Blower Co., an Ohio corporation with its principal office at Chicago, Ill., was organized in 1904, and is engaged in the business of manufacturing heating and ventilating apparatus.
The petitioners filed a consolidated return of net income and invested capital for the year under consideration. The petitioners' books of account show net earnings for the year as follows:
| Mathis Brothers Co | $696.60 |
| New York Blower Co | 13,850.01 |
| Total net earnings | 14,546.61 |
In the year in question, disbursements for fire insurance and watchman's wages, in the amounts of $184.34 and $45, respectively, and for the purchase of zinc used in the plant of one of the petitioners, *2623 in the amount of $350, and which were ordinary and necessary expenses of the businesses for that year, were erroneously charged to a capital asset account. The books have not been changed so far as these items are concerned, and they remain as charges to the capital asset account.
An examination of the petitioners' books of account was made by a revenue agent, who computed the consolidated net income as follows:
| Net income as shown by books: | ||
| Mathis Brothers Co | $696.60 | |
| New York Blower Co | 13,850.01 | |
| Consolidated net income per books | 14,546.61 | |
| Deduct nontaxable income: | ||
| Liberty bond interest | 93.39 | |
| $14,453.22 | ||
| Add unallowable deductions: | ||
| Patents written off | 2,026.80 | |
| Donations | 361.00 | |
| Federal income taxes | 2,003.33 | |
| Depreciation disallowed | 7,638.47 | |
| 12,029.60 | ||
| Consolidated net income subject to tax | 26,487.82 |
*340 Of the total depreciation disallowed by the revenue agent, $7,638.47, the Commissioner allowed $1,954.75, and, in the deficiency notice, determined the consolidated net income to be $24,533.07.
The charge of $2,026.80 against earnings of the year, which the revenue agent disallowed as a deduction from income, represented*2624 the writing off of two patents. One of these patents, issued in 1907, covered an air washer. Manufacture of the air washer and the use of the patent was discontinued in 1917. The other patent covered a multiple blade fan; and this use of this patent was discontinued in 1918, after litigation which resulted in a decision by a competent court that all multiple blade patents were invalid.
At July 31, 1916, 1917, and 1918, depreciable assets were carried on the petitioners' books of accounts at the values stated below:
| Book value at - | |||
| July 31, 1916 | July 31, 1917 | July 31, 1918 | |
| Mathis Brothers Co.: | |||
| Machinery and equipment | $11,648.25 | $11,323.14 | $11,376.01 |
| Furniture and fixtures | 2,010.00 | 1,931.62 | 1,997.76 |
| Total depreciable assets | 13,658.25 | 13,254.76 | 13,373.77 |
| New York Blower Co.: | |||
| Machinery and equipment | 28,471.19 | 24,164.00 | 28,214.27 |
| Supply tools | 3,731.74 | 2,862.27 | |
| Furniture and fixtures | 810.00 | 914.72 | 1,106.78 |
| Total depreciable assets | 33,012.93 | 27,940.00 | 29,321.05 |
| Total depreciable assets of both companies | 46,671.18 | 41,195.75 | 42,694.82 |
On the same dates, depreciation reserves were carried on the petitioners' books, in*2625 amounts as follows:
| Depreciation reserves | July 31, 1916 | July 31, 1917 | July 31, 1918 |
| Mathis Brothers Co | $5,425.49 | $7,433.15 | |
| New York Blower Co | $4,766.30 | 6,462.86 | 10,861.01 |
| Total depreciation reserves | 4,766.30 | 11,888.35 | 18,294.16 |
Prior to the fiscal year ended July 31, 1917, no depreciation reserve was set up on the books of the Mathis Brothers Co., but depreciation was accounted for by charges to profit and loss and credits to asset accounts, in amounts as follows:
| Depreciation charged off | |||
| Fiscal year ended July 31 - | Machinery and equipment | Furniture and fixtures | Total |
| 1904 | $2,206.52 | $2,206.52 | |
| 1905 | $956.47 | 956.47 | |
| 1906 | 1,294.46 | 1,154.86 | 2,449.32 |
| 1907 | 442.70 | 300.06 | 742.76 |
| 1908 | 473.36 | 473.36 | |
| 1909 | 105.00 | 105.00 | |
| 1910 | 403.74 | 3.75 | 407.49 |
| 1911 | 7.00 | 7.00 | |
| 1912 | 9.01 | 126.50 | 135.51 |
| 1913 | 222.01 | 170.75 | 392.76 |
| 1914 | 31.49 | 274.25 | 305.74 |
| 1915 | |||
| 1916 | 138.68 | 123.73 | 262.41 |
| 1917 | 458.43 | 1,106.69 | 1,565.12 |
| Total depreciation charged off by credits to asset accounts | 5,680.40 | 4,329.06 | 10,009.46 |
*341 The revenue agent, going back to the dates of organization of the petitioner*2626 companies, recomputed the accrued depreciation on the depreciable assets according to the "straight line" theory and by applying the rate of 15 per cent to the approximate book values (cost less depreciation credited to asset accounts) at the close of each year. The accrued depreciation, as thus computed by the agent, at July 31, 1916 and 1917, in respect of the depreciable assets of both petitioners, was equal to the book values of those assets at the dates stated; while at July 31, 1918, the accrued depreciation, in the case of Mathis Brothers Co., was $1,200 less than the book value of the assets, and, in the case of the New York Blower Co., was equal to the book value of the assets. Therefore, in computing invested capital, for the fiscal years 1917 and 1918, the revenue agent reduced book surplus by the book value of the depreciable assets of both companies, and for the fiscal year 1919, he reduced book surplus by all but $1,200 of the book value of those assets, and at the same time he restored to the book surplus the depreciation reserves on the books at the beginning of those years. The net result of the revenue agent's action is a reduction of invested capital for the fiscal*2627 years 1917, 1918, and 1919, for alleged inadequate depreciation charged off in prior years, by $41,904.88, $29,307.40, and $23,200.66, respectively.
For the fiscal year 1919, which is the taxable year under consideration, the Commissioner by three separate adjustments, in the deficiency notice, restored to invested capital $34,731.96 of the total book value of the depreciable assets at July 31, 1918, which the revenue agent had written off against surplus. The difference of $6,762.86 between the amount restored by the respondent and the book value of the assets, $41,494.82, written off by the revenue agent, *342 is the depreciation reserve on the books of the New York Blower Co., at July 31, 1917, the Commissioner having only restored the book value of the assets of the New York Blower Co., at July 31, 1918, less the depreciation reserve on that company's books at July 31, 1917. At the same time the Commissioner determined the accrued depreciation reserve for both petitioners at July 31, 1916, 1917, and 1918, to be $28,802.35, $31,135.70, and $33,195.50, respectively. The net result of the Commissioner's action is a reduction of invested capital for the year under consideration*2628 by $21,664.20, for alleged inadequate depreciation charged off in prior years.
In or about 1911, J. W. Mathis purchased his brother's stockholdings in the Mathis Brothers Co. for a consideration a part of which was evidenced by promissory notes. As these notes became due they were paid by the Mathis Brothers Co.; and the amounts so paid were charged on the books to "Treasury Stock" account. At July 31, 1918, the balance in the "Treasury Stock" account amounted to $29,316.26, the entire amount of which was the personal indebtedness of J. W. Mathis to the Mathis Brothers Co., for payment of the above described notes, and all of which has since been paid by J. W. Mathis. Mathis Brothers Co. never purchased any of its own capital stock; and the caption of the account "Treasury Stock" is a misnomer. Also, there was carried on the books of the Mathis Brothers Co. at July 31, 1918, an account receivable against C. W. Rogers, who is secretary of that company, in the amount of $7,086.76, for funds advanced by the company to that official, and by the latter used in purchasing shares of stock of the Mathis Brothers Co. from other stockholders. The account has been paid in full by Rogers. *2629 Both of these accounts were eliminated from invested capital by the revenue agent, but in the deficiency letter the sum of $17,136.70 was restored.
Land and buildings were carried on the books of the New York Blower Co., at July 31, 1918, at $1,765. The revenue agent held that the book value included appreciation of $1,000 and included these assets in invested capital at the value of $765. The Commissioner sustained the revenue agent's action.
Invested capital was increased by $15,768.50, the reason for which is set out in the deficiency notice as "Inventory Adjustment at 7-31-1917."
Invested capital was increased by $1,600, the reason for which is set out in the deficiency notice as "Machinery purchased and charged to income instead of to capital assets."
Invested capital was reduced by $2,763.22, for additional taxes for the fiscal years 1909 to 1917, inclusive, and by $1,778.21 for income and profits taxes of the fiscal year 1918, prorated from the dates the several installments became due and payable.
*343 Invested capital was reduced by $9,000, being the amount of the proceeds from the sale of certain properties by the New York Blower Co. to the American*2630 Clay Co., on the ground that the properties having been sold at cost the proceeds had been credited erroneously to income of a prior year, and book surplus was, therefore, overstated. The books of the New York Blower Co. show that the proceeds of the sale, in the amount of $9,000, were credited to the property accounts and were not included in income or book surplus.
OPINION.
MURDOCK: At the outset it should be stated that consideration of this case has been extremely difficult, because of the manner in which it has been presented to us. The petition does not contain, as the rules of the Board require, clear and concise assignments of error, nor a clear and concise statement of the facts upon which the petitioners rely as sustaining the assignments of error. Only after a very diligent study of the record as a whole have we been able to determine with any degree of certainty what the issues are which we are asked to decide. Considerable and fairly satisfactory evidence has been submitted by the petitioners of the nature of the respondent's various and sundry adjustments of net income and invested capital; but, generally speaking, the evidence of the facts upon which the petitioners*2631 rely to overcome the prima facie correctness of those adjustments is vague, indefinite, and unsatisfactory.
The first issue is that the Commissioner has overstated net income for 1919 by $33,967.31. No facts are set out in the petition in support of the assignment of error. At the hearing the petitioners presented evidence that items of expense were erroneously charged on the books of account to capital asset accounts, and of the circumstances surrounding the writing off of patents, in the amount of $2,026.80, which was not allowed as a deduction for the purpose of the tax. Statements of witnesses and of counsel for the petitioners at the hearing vaguely indicated that the total of expense items which were charged to capital asset accounts, and which should have been charged against income, amounted to approximately $1,936; but the evidence goes no further than to establish that fire insurance of $184.34, watchman's wages of $45, and purchases of zinc for use in the plant of one of the petitioners, in the amount of $350, were erroneously recorded on the books. The Commissioner's determination of net income is based upon the book accounts; and since he failed to make proper*2632 adjustments for expense items erroneously recorded therein, the net income shown in the deficiency notice is overstated $579.34.
*344 As to the charge against income of $2,026.80, representing the writing off of two patents, which was not allowed as a deduction, the evidence shows that one of these patents became obsolete and its use was discontinued in 1917, while a like fate befell the other one in 1918. The obsoleteness and discontinuance of the use of the one patent in 1917 occurred in a taxable year prior to that which we have under consideration, and clearly the loss incidental thereto is not a proper deduction from income of the latter year. On the other hand, since the year which we have under consideration began on August 1, 1918, the loss and discontinuance of the use of the other patent in 1918 may or may not constitute a proper deduction from the income of the year under consideration, depending on whether obsoleteness and discontinuance occurred after July 31, 1918, or before August 1, 1918. The evidence merely shows that obsoleteness and discontinuance occurred in 1918, and does not show the relation of the date of those happenings to the taxable year under*2633 consideration. Furthermore, there is no evidence as to what proportion of the amount written off applies to each patent; and had it been possible to find that obsoleteness and discontinuance of the use of the one patent in 1918 occurred within the year under consideration we would still have been unable to find the amount of the loss which the petitioners would be entitled to deduct. Under the circumstances we may not disturb the Commissioner's action in disallowing the deduction in question.
The second issue is that invested capital has been reduced erroneously because of alleged inadequate depreciation charged off in prior years. On examination of the evidence we find that on August 1, 1918, the beginning of the taxable year under consideration, the petitioners carried on their books of account depreciable assets of $42,694.82, and depreciation reserves, applicable to those assets, in the total sum of $18,294.16. The net book value of the petitioners' depreciable assets was, therefore, $24,400.66. The revenue agent who examined the petitioners' books for the year under consideration, by computing depreciation for each year from date of organization to the beginning of the*2634 taxable year according to the straight line theory and at the rate of 15 per cent per annum, determined that the accrued depreciation was sufficient to wipe out all but $1,200 of the book value of the petitioners' depreciable assets, and, accordingly, he reduced earned surplus and invested capital by $23,200.66. In the deficiency notice the sum of $34,731.96 was restored to invested capital, so that with the $1,200 included by the revenue agent, the depreciable assets were included therein at a gross value of $35,931.96, but the Commissioner then proceeded to reduce invested capital by accrued depreciation of $33,195.50, so that the depreciable assets were *345 included at a net value of $2,736.46, which is $21,664.20 less than their net book value.
Adding the depreciation of $10,009.46, which was credited to the asset accounts on the books of the Mathis Brothers Co., to the book value of $42,694.82, it is readily apparent that the cost of the depreciable assets was at least $52,704.28; and these same assets are included in invested capital, by the Commissioner, at a net value of $2,736.46, which is but a mere 5 per cent, approximately, of their cost. It would appear that*2635 if the depreciable assets served any useful purpose at all in the petitioners' businesses, their depreciated value would exceed a paltry 5 per cent of cost, which would appear to be hardly more than their salvage value; and the circumstances in this respect should not be difficult of proof. Yet, the record is entirely void of evidence which would support a finding that the Commissioner erred in his adjustment of invested capital. The only evidence we have is the testimony of the treasurer of the petitioner companies, who testified that in his opinion proper rates of depreciation are 4 per cent for furniture and fixtures and 5 per cent for machinery and equipment; and that an appraisal made in 1913 by an employee showed a then replacement value for the depreciable assets of the Mathis Brothers Co. and the New York Blower Co. of approximately $118,000 and $30,000, respectively. The appraisal, or inventory, was not placed in evidence, the witness explaining that he thought it had been destroyed. We know that the petitioner charged off certain amounts in prior years for depreciation, but we do not have any proof that the amounts charged off even approximated the depreciation actually*2636 sustained. We have no idea of what depreciation was sustained and we have no other alternative than to sustain the Commissioner in reducing invested capital by $21,664.20 for inadequate depreciation charged off in prior years.
The third and fourth issues are related and are considered together. At the beginning of the taxable year, Mathis Brothers Co. carried on its books a treasury stock account in the amount of $29,316.26, and an account receivable due from C. W. Rogers, its secretary, in the amount of $7,086.76. The revenue agent eliminated both of these assets from invested capital on the ground that they represented purchases by Mathis Brothers Co. of its own capital stock. Of the total amount eliminated by the agent, $36,403.02, the deficiency notice restored the sum of $17,136.70. Both of these asset accounts represented bona fide accounts receivable, for loans made by Mathis Brothers Co. to its executive officers, to permit those officials to purchase shares of stock of Mathis Brothers Co. from other stockholders, for their own account, and they have been paid in full. The Commissioner erred in failing to include both asset accounts in *346 full in invested*2637 capital; and the invested capital shown in the deficiency notice should be increased by the difference of $19,266.32.
The fifth issue is that the Commissioner erroneously reduced invested capital by $1,000, because of alleged appreciation in the book value of the land and buildings of the New York Blower Co. The sixth issue is that he erroneously increased invested capital by $15,768.50, because of an adjustment of the inventory of July 31, 1917. The seventh issue is that he erroneously increased invested capital by $1,600, because of understatement of the income of a preceding year through charging purchases of additional machinery to expense. No evidence was offered of the facts upon which the petitioners rely as sustaining any one of these assignments of error; and we may not disturb the Commissioner's action.
The eighth issue is that invested capital has been reduced on account of income and profits taxes of prior years erroneously computed. There is no evidence that the taxes for prior years have been erroneously computed; and, except for the fiscal year ended July 31, 1918, we have not the remotest idea as to how those taxes were computed. As to the fiscal year 1918, *2638 we have been unable to find any error by the Commissioner in the computation of the tax liability.
The ninth issue is that invested capital has been reduced erroneously by $9,000, on the ground that the New York Blower Co. had included in income of a prior year, and, therefore, in earned surplus, the proceeds from the sale of certain properties which were sold at cost. The evidence shows that the New York Blower Co. sold certain of its properties in a prior year to the American Clay Co., and that the proceeds of the sale, in the amount of $9,000, were credited to the property accounts and were not included in income and are not, therefore, included in the book surplus at the beginning of the taxable year. The Commissioner's action is erroneous and is reversed.
The tenth and last issue is that the Commissioner erred in failing to include in invested capital the cost of additions to plant and equipment, totaling $128,065, charged to expense in prior years and disallowed as deductions, in income-tax returns, by the Commissioner. The evidence is not sufficient to support this assignment of error. It consists only of the testimony of the petitioners' treasurer that additional*2639 taxes were assessed for prior years, the reason for which was explained to him by the revenue agent who examined the books for those years as the disallowance of deductions from income of capital expenditures; and that $55,000 was expended in 1913 for special machinery and equipment for producing mail boxes under a Government contract, all of which was charged to expense on the books. There is no evidence in the record that the assets, the cost of which *347 the petitioners ask to have restored to invested capital, were on hand and in use at the beginning of the taxable year; and though the petitioners' books of account were present at the hearings, no attempt was made to identify thereon costs of capital additions charged to expense in prior years. We are unable to find any error on the part of the Commissioner here.
Judgment will be entered on notice of 15 days, under Rule 50.
Considered by MORRIS, SIEFKIN, and TRAMMELL.